Veteran investor and Research Affiliates founder Rob Arnott believes investors should begin gradually reducing exposure to expensive U.S. growth stocks and look toward overlooked areas of the market that offer more attractive valuations.

While Arnott is not recommending an abrupt exit from growth stocks, he argues that the extraordinary gains enjoyed by large-cap technology and artificial intelligence leaders over recent years have left portions of the market historically expensive.

“I’d be worried about being complacent about a market that’s as expensive as it is today,” Arnott said in a recent interview. At the same time, he cautioned investors against making dramatic portfolio shifts, suggesting that any repositioning should occur gradually over months or even years.

Small-Cap Value Emerges as a Preferred Opportunity

One of Arnott’s highest-conviction opportunities is small-cap value stocks, a segment that has largely lagged behind the massive rally in large-cap technology companies.

According to Arnott, the valuation gap between small-cap and large-cap stocks has reached unusually wide levels. Historical data suggests such extremes have often preceded long periods of outperformance for smaller companies.

A Fidelity study examining market data since 1990 found that when small-cap valuations fall into their cheapest quintile relative to large-cap stocks, small-caps outperform over the following decade approximately 96% of the time.

Arnott believes the current disparity reflects one of the most stretched market environments in history.

To illustrate the imbalance, he noted that seven individual companies within the S&P 500 now possess larger market capitalizations than the entire Russell 2000 Value Index combined. Such concentration highlights how heavily investor capital has flowed into a handful of dominant mega-cap growth companies.

Value Versus Growth Reaches Historic Extremes

The divergence between value and growth investing has also reached unprecedented levels.

Driven largely by enthusiasm surrounding artificial intelligence, cloud computing, and semiconductor companies, growth stock valuations have expanded dramatically. Meanwhile, many traditional industries and smaller companies continue to trade at substantially lower multiples despite maintaining profitable operations and healthy balance sheets.

Arnott sees this as a classic setup where future returns may favor undervalued segments of the market rather than the most popular names.

Historically, periods of extreme valuation dispersion have often been followed by significant reversals as investors seek better risk-adjusted opportunities.

Emerging Markets Also Offer Attractive Valuations

Beyond U.S. small-cap value stocks, Arnott highlighted emerging-market value stocks as another area offering compelling long-term potential.

Research Affiliates data shows emerging-market equities currently trade at valuation levels cheaper relative to the S&P 500 than roughly 80% of observations dating back to 1996.

Despite concerns surrounding global growth, geopolitical uncertainty, and currency volatility, Arnott believes many emerging-market companies are being overlooked by investors focused almost exclusively on U.S. technology leaders.

Lower valuations provide a potential margin of safety while creating opportunities for stronger future returns if economic conditions improve.

Balancing Opportunity and Risk

Arnott’s recommendation is not a prediction that large-cap technology stocks will immediately collapse. Rather, he argues that future returns are increasingly likely to favor areas of the market where expectations remain low and valuations remain attractive.

His strategy centers on gradually diversifying away from heavily concentrated growth exposure and reallocating capital toward sectors and regions that have been largely ignored during the AI-driven bull market.

For long-term investors, the current environment may present an opportunity to position portfolios for a broader market rotation while maintaining balanced exposure across different asset classes and investment styles.